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Getting Blindsided

Nothing is worse than not knowing what is coming. The anxiety and nerves build up in us, we might even lose sleep over the fear of the unknown. That’s why it’s important to educate yourself with the real facts. Read more books, learn about the financial system, and most of all, don’t trust your banker. As I’ve written before, the banks are out there to make money. When they sell you a mortgage, it’s because the bank wants to make money, not because they want to help you to buy your dream home.

Many aspects that the bank doesn’t tell you about is how a mortgage works. Most of the time, the bank assesses your ability to pay a mortgage based on your current debt situation and your current income. Once that is determined, the bank will pre-approve the biggest mortgage they can give you and then you happily shop for the biggest house you can afford. It sounds great and dandy, you pay your monthly dues and you get a house to call your own. It’s sounds so wonderful and it’s living the North American dream. But wait, what is this thing about a fixed term for my contract? What happens at the end of this term? The answer is quite simple. The dance starts all over again.

My US friends generally don’t have the same problem that Canadians experience every 5 years. The US banking system is much different, and it’s not uncommon for home owners to be able to lock into fixed rate mortgages for 10 years, 15 years or even 30 years with for a lowly interest rate of only 4%. It’s almost like getting free money. For Canadians, the news isn’t as rosy. Fixed rate mortgages will only go so far as 10 years out from the major financial institutions and the majority of home owners in Canada choose to take out a 5 year fixed rate only. So what happens at renewal time? It’s anyone’s guess, but the fact is when renewal dates come up, you will need to renegotiate the terms of your mortgage again, just like how you did when you first bought your home.

Remember my last post about Amortized Interest and how during the first 5 years you’ve paid more in interest than your principal? When it comes time to renew your mortgage after 5 years, it’s the remaining principal that needs to be refinanced. So let’s take that example before where a $400k mortgage was taken out, amortized over 25 years with a 3.5% fixed rate for 5 years. In 5 years time, the principal to refinance will be $345 112.27. In order to maintain the schedule of payments you thought you had originally agreed to, interest rates would have to stay at 3.5%, you would have to amortized the remaining balance over 20 years and only if those two remain constant will your monthly payments continue to be $2000 a month.

The question you have to ask is this. Is this a reasonable assumption? Factors might play out such that it could happen. Anything is possible. The one thing that can fluctuate from time to time is interest rates. Those that bought 2 or 3 years ago can attest that interest rates have risen by over a percentage point since they last refinanced their mortgage. At that time, rates were sub 3% and some people may have signed their first mortgage at a measly 2.5%. With rates hovering closer to 4% than 3%, those people will be in for a price shock at renewal time.

So how much is a measly 1% gain on interest? Well remember my last article how you “pay up front”, well that 1% of interest gets shifted up front to your new payments as well, so let’s see how it gets impacted. In the above case after 5 years, your remaining principal is $345 112.27, you decide to renew at a 5 year fixed rate of 4.5% amortized over 20 years. You still want to pay off your house in your original 25 year time frame, right? So what’s your monthly: $2175.61.

Holy smokes! I have less to pay in my principal but I’m paying $175.61 more per month for just 1% rise in interest? What gives?

When it comes to amortizing the interest you have to remember that the arithmetic isn’t straight forward and simple. An amortized loan gets the entire portion of the interest spread out over the term of the years you agree to. Just because the interest rate goes up 1%, doesn’t mean that you pay 1% more (or $20 more) on your mortgage. That’s what Americans failed to realized, and it’s certainly a pitfall you want to avoid as well.

So what does the next 5 years look like now with your new payment schedule.

If you compare this chart with my previous post, you’ll soon realize that you are playing a game where the bank continually reaps more of your money as interest payments rather than principal payments. Not only do you have to pay more per month on your mortgage, but the thought that you would be paying more towards your principal in year 6 onwards is thwarted by higher interest rates. Why didn’t the bank warn you about this? It’s quite simple, they want to lock you in, they want your future business and they know that keeping you as a customer with a mortgage is best way to make more money off you.

So is this a warning not to buy a house? Certainly not, just be aware of the fact that interest rates are not forever and be wary of taking on a mortgage that is too large when time for renewal comes. It might hold true that current monthly payments are manageable in an interest low environment, but one has to factor in the risk of what may happen when the term of you mortgage expires. Don’t fall into the mistake that many Americans made when they didn’t understand that an increase of just a few percentage points on their interest would create a burden that would be too difficult to overcome.

This scenario would only hold true if interest rates rise. On the contrary, if rates were to lower then the opposite would happen and monthly payments may actually go down which would be benefiting to the home buyer. With recent news that the Bank of Canada may hold the prime rate steady throughout 2014 this might make you believe that you still have plenty of time before needing to worry about rising interest rates. Unfortunately this may not be the case. Stay tuned to my next post as I explain how mortgage interest rates are really set by the bank.